IN RE ARTHROCARE CORPORATION SECURITIES LITIGATION

<>ckquote Id. (quoting In Re Apple Computer, Inc. Secs. Litig., 243 F. Supp. 2d 1012, 1023 (N.D.Cal. 2002)). This is consistent, the Southland panel reasoned, with the general rule that in causes of action "where an essentially subjective state of mind" is one element of the cause of action along with some sort of act or omission, the required state of mind must exist in the individual who performs the act or omission (or causes it to be performed), "and may not simply be imputed to that individual on general principles of agency." Id. Thus, "[w]hile . . . a corporation may be charged with the collective knowledge of its employees, it does not follow that the corporation may be deemed to have a culpable state of mind when that state of mind is possessed by no single employee"; instead, "[a] corporation can be held to have a particular state of mind only when that state of mind is possessed by a single individual." Id. at 367 (emphasis added) (quoting First Equity Corp. v. Standard Poor's Corp., 690 F. Supp. 256, 260 (S.D.N.Y. 1988)). This means, in practice, that plaintiffs must "distinguish among defendants and allege the role of each" in pleading corporate scienter. Fin. Acquisition Partners LP v. Blackwell, 440 F.3d 278, 287 (5th Cir. 2006).

In Southland, the Fifth Circuit concluded by noting the plaintiffs had not alleged that "any individual [corporate] director, officer, or employee other than the named individual defendants had acted with scienter in or respecting the making or issuing of any of the complained of statements or in ordering or approving any of such statements or furnishing information or language for inclusion therein or omission therefrom, or the like." 365 F.3d at 367. As a result, the Southland court found it was only necessary "to address the allegations claimed to adequately show such state of mind on the part of the individual defendants." Id. The present case is identical in that respect: Plaintiff has not alleged any individual ArthroCare director, officer, or employee other than the named defendants — Baker, Gluk, Applegate, and Raffle — acted with scienter. Therefore, the Court must look to the state of mind of those Defendants to determine whether Plaintiff has pled an inference of scienter with respect to ArthroCare.

i. Scienter of the Individual Defendants

First, ArthroCare claims the CCAC does not adequately allege corporate scienter because it does not adequately allege the scienter of either Baker or Gluk, and therefore no scienter can be imputed to ArthroCare. However, the Court finds — as discussed, supra — that Plaintiff has adequately alleged the scienter of Baker and Gluk after December 11, 2007, and therefore this argument is foreclosed at least after that time. See supra, sec. (1)(C). Because the CCAC contains pleadings establishing the requisite level of scienter on the part of Baker and Gluk after December 11, 2007, the CCAC also establishes the requisite level of scienter on the part of ArthroCare after December 11, 2007.

ii. Scienter of the Control Person Defendants

Plaintiff also argues the scienter of Applegate and Raffle is relevant to whether scienter has been pled on the part of ArthroCare, as the Control Person Defendants allegedly acted deliberately in omitting or affirmatively misrepresenting information "for inclusion in various public filings or reports." Pl.'s Resp. at 23-24. The Southland panel did imply, in passing, that a corporation acts with scienter where the employee who furnished the "information or language for inclusion therein or omission therefrom" acted with scienter. 365 F.3d at 367. But the panel also explained, as stated above, that "[a] corporation can be held to have a particular state of mind only when that state of mind is possessed by a single individual." Id. at 367 (emphasis added). "The PSLRA requires the plaintiffs to distinguish among those they sue and enlighten each defendant as to his or her particular part in the alleged fraud" by pleading "specific factual allegations" linking each corporate officer to a statement, such as "a signature on the document or particular factual allegations explaining the individual's involvement in the formulation of either the entire document, or that specific portion of the document containing the statement." Id. at 365.

In the present case, Plaintiff does not offer any specific factual allegations linking Raffle or Applegate to any specific document, portion of a document, transaction, financial statement, or any other representation by ArthroCare. Plaintiff does not allege whether Raffle or Applegate provided the information, drafted the language, or authorized its inclusion. Without specific allegations of this type, the CCAC lacks the specificity to establish that either Raffle or Applegate acted with scienter. Although Plaintiff points out repeatedly that ArthroCare expressly admitted the actions of Raffle and Applegate "led to" various accounting errors and irregularities identified in the Restatement, this bare statement is simply not sufficient to infer either Raffle or Applegate acted with scienter (as opposed to negligence). To allow Plaintiff to impute scienter to ArthroCare on the basis of this single statement would be to embrace the group pleading doctrine specifically rejected by the Southland court. Because Plaintiff has not pled a single particular fact which give rise to a strong inference that either Raffle or Applegate was connected with any particular false statement or omission by ArthroCare or acted with scienter, the Court rejects this basis for imputing scienter to ArthroCare.

iii. Conclusion

In accordance with the foregoing, the Court finds ArthroCare's motion to dismiss should be GRANTED in part and DENIED in part. As with the Individual Defendants, the CCAC pleads allegations which give rise to a strong inference of scienter on the part of ArthroCare after December 11, 2007, but not before.

C. Control Person Claims

ArthroCare claims Plaintiff has failed to state a valid control person claim against either Raffle or Applegate. As is discussed at length in sections III and IV, this Court agrees. ArthroCare's motion to dismiss is therefore GRANTED on this ground.

III. Defendant David Applegate's Motion to Dismiss [#169]

A. Legal Standard for Control Person Claims

Plaintiff seeks to hold Defendant Applegate liable on a single ground: as a "control person" pursuant to § 20(a). 15 U.S.C. § 78t(a). Section 20(a) states anyone "who, directly or indirectly, controls any person liable [for Exchange Act violations] shall also be liable . . . to the same extent as such controlled person[.]" Id. The Fifth Circuit has held "[t]he legislative history of . . . § 20(a) demonstrates that Congress enacted [it] to address the specific evil of persons seeking to evade liability under the acts by organizing `dummies,' who, acting under their control, would commit the prohibited acts." Paul F. Newton Co. v. Texas Commerce Bank, 630 F.2d 1111, 1118 (5th Cir. 1980) (citations omitted).

"Control person" liability is, of course, derivative — it is predicated on the existence of an independent violation of the securities laws. Rubinstein v. Collins, 20 F.3d 160, 166 n. 15 (5th Cir. 1994); Lovelace v. Software Spectrum Inc., 78 F.3d 1015, 1021 n. 8 (5th Cir. 1996). Because the Court finds Plaintiff has stated a predicate claim under § 10(b), the Court proceeds to consider the control person claims under § 20(a).

There are two distinct components to a § 20(a) claim: (1) a primary violation by a controlled person; and (2) direct or indirect control of the primary violator by the defendant. In re TETRA Techs., Inc. Secs. Litig., 2009 WL 6326865 (S.D. Tex. 2009) (citing Dennis v. General Imaging, Inc., 918 F.2d 496, 509 (5th Cir. 1990)). The heightened pleading requirements of the PSLRA and Rule 9(b) do not apply to control person violation claims. Trendsetter Investors, LLC v. Hyperdynamics Corp., 2007 WL 172627 at *15 (S.D. Tex. 2007).

B. Application to the Present Case

From 2004 to 2008, Applegate was Senior Vice President and General Manager of ArthroCare's Spine division. CCAC at ¶¶ 21-22. Applegate claims he did not control the actions of the primary violators — Baker (CEO) and Gluk (CFO) — during that time. See Applegate's Mot. Dismiss at 11. In fact, these men were clearly his corporate superiors based on their titles and positions within the company. Id. Applegate also claims he did not have control over Baker and Gluk's material misrepresentations or omissions to the investing public (which are the basis of their alleged § 10(b) violations). There is no allegation in the CCAC that Applegate actually made any statements to the public or was personally involved in any way in any false or misleading statements, nor is there an explanation for how he could have controlled such promulgations by Baker and Gluk, who were undeniably his superiors at ArthroCare.

Plaintiff claims whether Applegate controlled Baker and/or Gluk is a question of fact for the jury. Pl.'s Resp. [#184] at 5-6. It is true that "[d]etermining who is a controlling person is usually an intensely factual question, involving scrutiny of the defendant's participation in the day-to-day affairs of the corporation and the defendant's power to control corporate actions." Howard v. Everex Systems, Inc., 228 F.3d 1057, 1065 (9th Cir. 2000) (internal quotations and citations omitted). However, a plaintiff cannot simply base a control person claim on boilerplate allegations; instead, the plaintiff must provide some factual support which indicates the control person defendant was in a position to control a primary violator. In this case, Plaintiff has alleged no specific facts in the CCAC which would indicate Applegate did in fact control Baker or Gluk; in fact, Plaintiff eschewed even making this claim at the hearing. This issue is similar to that raised in Middlesex Retirement System v. Quest Software Inc., in which a district court considered a control person claim levied against one of the vice presidents of Quest based on the allegation he controlled the actions of his corporate superiors, and held:

Plaintiff did not allege, and it is difficult for the Court to determine how, as a Vice President, [the defendant] was able to exercise control over the other 10b-5 Defendants when the other 10b-5 Defendants held positions of Vice President or higher; i.e., how can [the defendant] exercise control over either his peer Vice Presidents or his supervisors[?] Moreover, Plaintiff has not alleged how [he] exercised control over Quest. . . . Plaintiff has not alleged that [he]caused Quest to file any misstated financial statements. Thus, for Plaintiff to establish [the defendant]'s control person liability, Plaintiff must provide factual support that [he] was in a position to control a primary violator.

527 F. Supp. 2d 1164, 1194 (S.D. Cal. 2007). Likewise, this Court finds there is no genuine issue of material fact as to whether Applegate controlled Baker and/or Gluk — he did not.

However, Plaintiff also makes the marginally stronger argument that the "controlled person" in this case was ArthroCare, rather than either of the Individual Defendants. This assertion requires a showing that Applegate "had the requisite power to directly or indirectly control or influence corporate policy," including facts demonstrating Applegate "had an ability to control the specific transaction or activity upon which the primary violation is based." Zagami v. Natural Health Trends Corp., 540 F. Supp. 2d 705, 716 (N.D. Tex. 2008) (citations omitted). In the CCAC, Plaintiff alleges Applegate, by virtue of his "high-level position, [his] ownership and contractual rights, participation in and/or awareness of [ArthroCare]'s operations and/or intimate knowledge of the false financial statements filed by [ArthroCare] with the SEC and disseminated to the investing public, . . . had the power to influence and control, and did influence and control, directly or indirectly, the decisionmaking of" ArthroCare. CCAC at ¶ 571. Plaintiff asserts Applegate "was provided with or had unlimited access to copies of [ArthroCare]'s reports, press releases, and public filings and other statements alleged by Plaintiffs to be misleading prior to and/or shortly after these statements were issued and had the ability to prevent the issuance of the statements or cause the statements to be corrected." Id. In particular, Plaintiff alleges Applegate had "direct and supervisory involvement in the day-to-day operations of [ArthroCare] and, therefore, is presumed to have had the power to control or influence the particular transactions giving rise to the securities violations alleged herein, and exercised the same." Id. at ¶ 572. Plaintiff cites the Restatement — in which ArthroCare admitted Applegate's and Raffle's actions primarily led to the accounting errors and irregularities — as further support for its claims. Id. at ¶ 573.

Cutting through this rhetoric, it is determinative that Plaintiff nowhere alleges Applegate actually controlled the public dissemination of the false statements in question. Plaintiff essentially pleads facts indicating Applegate controlled some of the underlying operations about which misrepresentations were made in ArthroCare's public filings and statements, but not that he controlled the public filings and statements themselves. To adequately plead a control person claim, a plaintiff "must plead facts indicating that the defendant `had the requisite power to directly or indirectly control or influence corporate policy,'" including facts indicating the defendant had the ability to control the specific activities on which the primary violations are based. Zagami, 540 F. Supp. 2d at 716 (quoting Kunzweiler v. Zero.Net, Inc., 2002 WL 1461732 at *13 (N.D. Tex. 2002)). In this case, it is ArthroCare's financial reporting — not the underlying operations or transactions themselves — which forms the basis of Plaintiff's primary claims against the Individual Defendants. Thus, because there is no allegation Applegate signed any of the press releases or SEC forms which contained the misstatements or omissions, or had final authority over any of ArthroCare's public statements or filings — in other words, because there is no allegation that Applegate had substantial control over the dissemination of any false information to the public, which is the basis of Plaintiff's § 10(b) claims — he cannot be held liable as a control person simply due to his involvement in the underlying activities about which the Individual Defendants are alleged to have misled investors.

In short, Plaintiff has not alleged Applegate had authority over the preparation of the financial statements or press releases or conference calls containing the misleading statements, and thus Plaintiff has not stated a valid control person claim against Defendant Applegate. Applegate's motion to dismiss is hereby GRANTED.

At most, the allegations in the CCAC indicate Applegate was a secondary actor who aided and abetted Baker and Gluk in their primary violations of § 10(b). But the Supreme Court has explicitly found "the 1934 [Exchange Act] does not itself reach those who aid and abet a § 10(b) violation." Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 177. To hold otherwise, it explained, would be to "impose . . . liability when at least one element critical for recovery under 10b-5 is absent: reliance." Id. at 180.

IV. Defendant John T. Raffle's Motion to Dismiss [#170]

During the Class Period, Raffle was the Vice President of Strategic Business Units for ArthroCare. He also ran DRS — he incorporated DRS on behalf of ArthroCare, and acted as President, Treasurer, and Sole Director of DRS. CCAC at ¶ 81. Like Applegate, Raffle is sued solely under § 20(a), and his motion raises essentially the same law and arguments on control person liability as Applegate's. Thus, the resolution of it is the same. Although Plaintiff makes much of the fact ArthroCare admitted in a press release that "[f]acts identified in the [r]eview indicate that actions employed by senior sales management, including [Raffle] . . ., primarily led to the accounting errors and possible irregularities now being considered as part of the Company's financial restatement," Pl.'s Resp. at 9-10, the fact Raffle's actions led to or caused various accounting errors or irregularities has nothing to do with whether he controlled the material misrepresentations disseminated by the Individual Defendants and ArthroCare that form the basis for the § 10(b) claims in this case. Plaintiff does not allege Raffle had general control over either of the Individual Defendants, ArthroCare, or over any public statement, filing, or conference call associated with ArthroCare. Because Plaintiff has not alleged any facts demonstrating Raffle controlled the particular acts alleged to have violated the securities laws in this case, Plaintiff has failed to state a control person claim against Defendant Raffle. Raffle's motion to dismiss is therefore GRANTED.

V. Defendant PriceWaterhouseCooper's Motion to Dismiss [#171]

PwC claims the facts pled in the CCAC do not give rise to an inference of fraud on the part of PwC, and instead give rise to an inference PwC did not act with scienter, as Plaintiff acknowledges that ArthroCare admitted its own personnel misled PwC about the accounting irregularities that led to the Restatement. PwC's Mot. Dismiss at 12.

A. Legal Standard

Plaintiff's claims against PwC also arise under § 10(b) and Rule 10b-5, and thus Plaintiff must satisfy the heightened pleading requirements imposed by Rule 9(b) and the PSLRA to avoid dismissal of these claims. Again, § 10(b) and Rule 10b-5 require proof the defendant acted with "scienter" — i.e., "a mental state embracing intent to deceive, manipulate, or defraud." Tellabs, 551 U.S. at 319. Both intent and "severe recklessness" are sufficient to satisfy the substantive scienter requirement. Nathenson, 267 F.3d at 407-08. Many circuit courts have concluded the meaning of recklessness in securities fraud cases is "especially stringent" when the claim is made — as it is here — against an outside auditor. See, e.g., PR Diamonds, Inc. v. Chandler, 364 F.3d 671, 693 (6th Cir. 2004). Specifically, "[r]ecklessness on the part of an independent auditor entails a mental state so culpable that it `approximate[s] an actual intent to aid in the fraud being perpetrated by the audited company." Id. (quoting Decker v. Massey-Ferguson, Ltd., 681 F.2d 111, 121 (2d Cir. 1982)); Rothman v. Gregor, 220 F.3d 81, 98 (2nd Cir. 2000). It must be proven not merely that there was a deviation from accounting principles, but

. . . that the accounting practices were so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts.

PR Diamonds, 364 F.3d at 693-94 (quoting In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir. 1994)). Thus, "to allege that an independent accountant or auditor acted with scienter, the complaint must allege specific facts showing that the deficiencies in the audit were so severe that they strongly suggest that the auditor must have been aware of the corporation's fraud." Id. at 694; In re SmarTalk Teleservices, Inc. Secs. Litig., 124 F. Supp. 2d 505, 514 (S.D.Ohio 2000); Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1570 (9th Cir. 1990).

B. Application to the Present Case

The CCAC alleges PwC served as ArthroCare's outside auditor during the entire Class Period. CCAC at ¶ 405. In that role, it issued audit opinions about ArthroCare's financial statements that were included in its Form 10-Ks for the years ended December 31, 2005, 2006, and 2007. Id. These three audit opinions are the sole source of false statements made by PwC. Plaintiff alleges the audit opinions PwC issued each year during the Class Period were false and misleading in that they claimed ArthroCare's fiscal year-end financial statements were correct. In an attempt to raise a strong inference of scienter on the part of PwC with respect to the allegedly false audit opinions, Plaintiff pleads the following particularized facts: (1) PwC had been ArthroCare's outside auditor since its initial public offering, CCAC at ¶ 24; (2) PwC had broad access to ArthroCare's accounting records and information, id. at ¶ 466; (3) the financial statements had numerous violations of GAAP and GAAS, id. at ¶¶ 405, 455-6; (4) PwC ignored 31 specific red flags that should have alerted it to the existence of fraud at ArthroCare over the course of nine years, id. at ¶¶ 427, 456; and (5) PwC made millions of dollars in audit and audit-related fees, which provided its motivation to commit fraud. Id. at ¶ 475. The Court will discuss each allegation in turn, and then consider them as a whole.

GAAS are standards established by the Auditing Standards Board of the American Institute of Certified Public Accountants for the conduct of auditors in the performance of an examination.

i. Independence of PwC

The allegation PwC was ArthroCare's auditor from its initial public offering until the time of the Restatement is essentially a charge that PwC was not truly "independent" because of its long-standing relationship with ArthroCare. Likewise, the allegations regarding the amount of audit and audit-related fees paid to PwC by ArthroCare also go to whether PwC was truly independent from ArthroCare. Courts have generally held allegations there was a long-standing relationship between the auditor and the company, or that the auditor gained financially by participating in or recklessly disregarding a client company's fraud, are not sufficient under the PSLRA's heightened pleading standard to raise an inference of fraud. See In re Dell, 591 F. Supp. 2d at 900; Melder v. Morris, 27 F.3d 1097, 1103 (5th Cir. 1994). Of course, if the outside auditing firm is paid exorbitant "consulting fees" — so that it earns more for consulting than for auditing the client — or otherwise gains some sort of "dual role" with respect to the company, this may add to an inference of scienter. In re Fleming Comps., Inc. Sec. Litig., 2004 WL 5278716, at *40 (E.D. Tex. 2004). But in the present case there are no indications PwC had gained any "dual role" with respect to ArthroCare, or that the fees PwC earned were in any way abnormal or exorbitant. Thus, without more, the mere allegation that PwC had a long-standing relationship with ArthroCare and was paid fees for its work do not add to any inference of scienter on the part of PwC.

ii. Access to books and records

Plaintiff also alleges PwC had broad access to ArthroCare's accounting records and information. It it is well established that merely pleading access to a company's private records, without more, does not adequately allege scienter. See Fin. Acquisition Partners, LP v. Blackwell, 2004 WL 2203253, at * 23 (N.D. Tex. 2004) (citing Arnlund v. Deloitte Touche, 199 F. Supp. 2d 461, 477 (E.D. Va. 2002)). However, Plaintiff does present at least one confidential witness (CW 16, a former Controller and Director of Global Accounting who worked at ArthroCare from June 2006 through June 2007) who testifies that PwC was provided information regarding the manner in which ArthroCare intended to account for its transactions with DiscoCare, and PwC initially stated the proposed accounting was improper (because they should be accounted for as related-party transactions, as ArthroCare later admitted). CCAC at ¶ 467. However, PwC subsequently issued a clean opinion on the financial statement. Id. This specific testimony may be sufficient to raise a slight inference of scienter; however, it is at least as plausible that PwC simply changed its opinion about what was the proper accounting for the DiscoCare transaction, perhaps because PwC was given misleading information by ArthroCare executives.

iii. Magnitude of fraud and accounting errors

Plaintiff also alleges the plethora of later-identified GAAP and GAAS violations, taken with the other allegations, establish a strong inference of scienter. The Fifth Circuit has concluded "the mere publication of inaccurate accounting figures or failure to follow GAAP, without more, does not establish scienter;" instead, as in other areas, a plaintiff must show the accounting firm deliberately misrepresented material facts or acted with severe recklessness as to the accuracy of its audits or reports. Abrams, 292 F.3d at 432; Melder, 27 F.3d at 1103 ("boilerplate averments that the accountants violated particular standards are not, without more, sufficient to support inferences of fraud"). Such violations, on their own, simply do not represent the extreme departure from the standards of ordinary care that the recklessness standard requires. Thus, in the absence of additional facts specifying fraudulent intent or the defendant's state of mind, GAAP errors "merely suggest that either management or the accountant missed something, and may have failed to prepare or review the financial statements in accordance with an accepted standard of reasonable care." In re Baker Hughes Sec. Lit., 136 F. Supp. 2d 630, 649 (S.D. Tex. 2001).

However, violations of GAAP (such as were recognized in the Restatement) may give rise to an inference of fraudulent intent when they are particularly egregious or are coupled with other specific and properly pled allegations of fraud. See S.E.C. v. Casarta, 75 F. Supp. 2d 79, 94-95 (E.D.N.Y. 1999). Similarly, a restatement may add significant weight to the scienter calculus based on the magnitude of a restatement, the repetitiveness of GAAP violations requiring the restatement, and the simplicity of the violated accounting principles. In re Fleming, 2004 WL 5278716 at *37. Thus, while a financial restatement by itself is not sufficient to raise a strong inference of scienter, "significant overstatements of revenue tend to support the conclusion that the defendants acted with scienter" when coupled with "other allegations that take into account and measure the relative seriousness of the restatement[.]" In re Seitel, Inc. Secs. Litig., 447 F. Supp. 2d 693, 705 (S.D. Tex. 2006). But a court may not rely on "hindsight, speculation and conjecture" to infer that just because the restatement was large, the fraud must have been so obvious and conspicuous that the auditor either knew of the fraud or was severely reckless in not knowing of it. See Reiger v.Price Waterhouse Coopers, LLP, 117 F. Supp. 2d 1003, 1013 (S.D. Cal. 2000). Instead, there must be specifically pleaded warning signs indicating such an assumption is merited. Id.

In the instant case, the allegations of GAAP and GAAS violations on the part of PwC, on their own, add nothing to the inference of scienter on the part of PwC. It is undisputed the financial statements issued during the Class Period were not, in many ways, prepared in accordance with GAAP. But this alone cannot establish an inference of scienter on the part of PwC. Plaintiff sets forth a boilerplate, un-particularized list of alleged GAAP and GAAS violations on the part of PwC, alleging these somehow give rise to an inference of scienter, but the Court disagrees. See, e.g. CCAC at ¶ 425 ("PwC violated GAAS by failing to exercise due processional care in the performance of the ArthroCare audits."); ¶ 413 ("It cannot be argued reasonably that PwC fulfilled its responsibility in gathering competent evidential matter to support its audit opinion"). Plaintiff does not allege any specific information about what PwC actually did in its audits of ArthroCare, but instead relies on the circular reasoning that PwC must have acted with scienter simply because it did not catch the misstatements and GAAP violations in ArthroCare's financial statements that were later identified in the Restatement. See, e.g. CCAC at ¶ 415 ("The fact that PwC failed in its role as gatekeeper, did not have the required level of understanding of ArthroCare's business, and did not conduct audits in accordance with GAAS is patently obvious upon consideration of the fact that PwC was ArthroCare's independent auditors [sic] for years but failed to uncover basic GAAP departures in the financial statements."); id. at ¶ 449 ("If PwC had performed a proper evaluation, PwC should have uncovered that ArthroCare's control environment appeared to be overly driven by sales generation, resulting in senior management's lack of significant appreciation for internal controls over financial reporting and accounting principles relating to revenue recognition."). In fact, the large majority of Plaintiff's pleading on this issue consists of long explanations of each GAAS principle allegedly violated, followed by the conclusory statement that PwC "clearly" violated that principle based solely on fact the Restatement was issued.

The GAAS standards acknowledge "even a properly planned . . . audit may not detect a material misstatement," AU § 230.12; thus, the mere fact the audits apparently did not catch the later-revised accounting errors in the financial statements is not conclusive. In re Dell, 591 F. Supp. 2d at 903. Plaintiff does not plead any specific details indicating how or when PwC became aware of the misstatements in ArthroCare's earlier disclosures, what PwC's audit entailed, what the basis is for the assumption PwC did not perform appropriate testing (aside from the very fact of the Restatement), how the supposedly missed tests would have revealed the fraud in question, or why there is any reason to believe the alleged deficiencies were purposeful or reckless. See id.; Reiger v.Price Waterhouse Coopers, LLP, 117 F. Supp. 2d 1003, 1013 (S.D. Cal. 2000). This Court will not rely on "hindsight, speculation and conjecture" to infer that just because the Restatement was large, the fraud in question must have been so obvious that PwC either knew of the fraud or was severely reckless in not knowing of it. Reiger, 117 F. Supp. 2d at 1013. Plaintiff must specifically plead the existence of warning signs that indicate such an inference is merited, as the magnitude of fraud supports an inference of scienter "only when the plaintiff pleads specific and detailed facts showing that the magnitude either enhanced the suspiciousness of specifically identified transactions, or made the overall fraud glaringly conspicuous." Id.

It is important to remember there are "potentially [an] infinite number of innocuous reasons an accountant may fail to detect a fraud of large magnitude" — for example, the fraud may have stemmed "from improprieties in transactions that fell outside the scope of the audit, or from manipulations the company concealed from its accountant and the public." Id. (citing In re Livent, Secs. Litig., 78 F. Supp. 2d 194, 217 (S.D.N.Y. 1999)). For this reason, it is well-settled the mere fact an auditor failed to detect a fraud of large magnitude cannot establish scienter on the part of the auditor. See, e.g. Ind. Elec., 537 F.3d at 534.

iv. Red flags

Plaintiff has attempted to plead the existence of warning signs by claiming PwC ignored a substantial number of red flags — "those facts which come to the attention of an auditor which would place a reasonable auditor on notice that the audited company was engaged in wrongdoing to the detriment of its investors." In re Dell, 591 F. Supp. 2d at 904. In certain circumstances, courts have held allegations of GAAP or GAAS violations, coupled with allegations of deliberately ignoring "red flags," can be sufficient to state a claim of securities fraud. Ziemba v. Cascade Int'l, Inc., 256 F.3d 1194, 1209-10 (11th Cir. 2001); In re Enron, 235 F. Supp. 2d at 677-79, 706-07. A red flag creating a strong inference of scienter generally consists of "[a]n egregious refusal to see the obvious, or to investigate the doubtful." P.R. Diamonds, Inc., 364 F.3d at 695.

In this case, Plaintiff alleges ArthroCare's improper revenue recognition practices — such as the fact ArthroCare increased the price of Spine Wands 500% while simultaneously increasing sales of Spine Wands by 95% in 12 months, or the fact ArthroCare habitually entered into major transactions within the last few days of the quarter — were red flags that should have been glaringly obvious to PwC and should have caused it to inquire further into ArthroCare's revenue recognition practices. CCAC at ¶¶ 71, 206-07, 265, 527. Plaintiff also points out the extensive news articles which began in December 2007 and ultimately triggered the Restatement (discussed supra), the "obvious" lack of internal controls, the improper accounting for the DiscoCare acquisition (which PwC recommended against, but later signed off on), and numerous alleged accounting violations. See CCAC at ¶ 427. Plaintiff alleges the only way PwC could have missed these "flagrant warning signs" is by turning a blind eye and disregarding the most basic requirements of GAAS. Pl.'s Resp. at 23.

However, the Court finds none of the red flags are sufficient to establish a strong inference of scienter on the part of PwC because not a single "red flag" establishes PwC knew or recklessly disregarded information at the time it conducted its audits and quarterly reviews. In fact, the pleadings do not even indicate whether PwC was contemporaneously aware of any of the red flags in question. A red flag creating a strong inference of scienter consists of "[a]n egregious refusal to see the obvious, or to investigate the doubtful." PR Diamonds, 364 F.3d at 695. The majority of the purported red flags listed by Plaintiff are the same conclusory accounting violations detailed above, which are present in almost every securities fraud action. The only genuine red flag is the "extensive news articles beginning in December 2007 that alleged the exact schemes and proprieties that triggered the Restatement less than two years later." CCAC at ¶ 427. However, it is certainly plausible that this red flag failed to put PwC on notice on the fraud because ArthroCare concealed the fraud so well that PwC itself was deceived. The language of ArthroCare's December 19, 2009 press release reads:

Facts identified in the Review indicate that actions employed by senior sales management . . . primarily led to the accounting errors and possible irregularities now being considered as part of the Company's restatement. Those actions included failing to communicate and/or withholding key information and practices bearing on revenue recognition and other accounting issues to [the accounting staff and PwC].

CCAC at ¶ 312. It is certainly possible that until May 2008, when PwC's general counsel office received a series of anonymous faxes which contained substantially the same allegations as the press reports, id. at ¶ 324, PwC simply believed Baker's vehement denials of the news stories.

v. Conclusion

Based on all the foregoing, the Court finds Plaintiff has not pled sufficiently particularized facts demonstrating PwC had the requisite level of intent. The inference that PwC intended to deceive investors is far less compelling than the competing inference of non-fraudulent intent. See Tellabs, 551 U.S. at 314. Importantly, Plaintiff has not alleged any facts supporting a motive to deceive, or any theory as to why PwC would knowingly mislead investors. At most, Plaintiff has alleged — in a highly conclusory fashion — negligent conduct on the part of PwC. But Plaintiff cannot recover without proving PwC acted "with an intent to deceive — not merely innocently or negligently," Merck Co., Inc. v. Reynolds, 130 S.Ct. 1784, 1796 (2010) (emphasis in original). Therefore, PwC's motion to dismiss is GRANTED.

Conclusion

In accordance with the foregoing,

IT IS ORDERED that Defendant ArthroCare Corporation's Motion to Dismiss [#166] is GRANTED IN PART and DENIED IN PART, in accordance with the foregoing order.

IT IS FURTHER ORDERED that Defendant Michael Baker's Motion to Dismiss [#172] is GRANTED IN PART and DENIED IN PART, in accordance with the foregoing order.

IT IS FURTHER ORDERED that Defendant Michael Gluk's Motion to Dismiss [#169] is GRANTED IN PART and DENIED IN PART, in accordance with the foregoing order.

IT IS FURTHER ORDERED that Defendant Applegate's Motion to Dismiss [#168] is GRANTED.

IT IS FURTHER ORDERED that Defendant John T. Raffle's Motion to Dismiss [#170] is GRANTED.

IT IS FURTHER ORDERED that Defendant PriceWaterhouseCooper's Motion to Dismiss [#171] is GRANTED.

IT IS FINALLY ORDERED that Plaintiff's Motion for Leave to File a Sur-Reply to Baker's Motion to Dismiss [#200] is GRANTED.

SIGNED this the 20^th day of July 2010.